And None of the Piggies Go to Market
And None of the Piggies Go to Market
Competition for Fed liabilities is mounting, and will constrain credit, and risk assets
A simple story of three little pigs, none of whom want to go to (stock) market.
The first little pig is at home, and doesn’t want to move. Reserve balances of banks held at the Fed are the safest and most liquid short-maturity assets available; the best asset to satisfy High Quality Liquid Asset (HQLA) requirements. Due to the highly unusual configuration of the yield curve - a product of Fed policy - reserve balances also pay the highest return of safe dollar asset. The Fed’s actions to calm recent banking fears was a response to increased demand from banks for this low risk, high return assets; unofficial reserve requirements have increased. This is how monetary tightening works. Plus, credit creation is not driven by the level of interest rates, but by the return expected from maturity transformation. Maturity transformation is currently loss-making, so credit is being constrained. This little pig shows no signs of wanting to leave his home unless he is tempted by big rate cuts - probably in excess of 200bps of cuts.
The second little pig has also decided it isn’t going to move until the yield curve dis-inverts. The ONRRP has been and remains a appetising food trough for non-bank savers. Some of that will end up on bank balance sheets as repo (where banks will pay a high interest rate against collateral, crimping profits), but most will end up at the Fed. That little pig is not coming to market without a significant turn about in Fed policy that takes away his meal.
The third little pig is the Treasury General Account. This little pig has been going ‘wee, wee, wee’ since January 2023, when special measures were introduced to deal with debt ceiling restrictions. Since then the Treasury has drawn US$500 bln from its Fed account to keep the lights on. The US$500 bln squealing from this little piggy may be why risky assets have taken so little notice of strains in liquidity. Perhaps this little piggy has gone to the stock market.
But this little pig isn’t able to go ‘wee, wee’ much longer. At US86 billion the Treasury General Account (TGA) is the lowest since the last debt ceiling crisis in December 2021. Yes, tax receipts in April will boost the TGA, maybe by US$100-200bln, allowing a little more squealing. But drawdown will begin again immediately and even a good April tax intake won’t stop a further draw on the TGA.
If there is no debt ceiling deal, then expect mayhem on a global scale. But if there is a debt ceiling deal, as we all hope and expect, the Treasury will need to rebuild the TGA. That means an increase in competition for Fed liabilities. In practical terms, with the current yield curve configuration, this means credit creation becomes significantly less attractive and liquidity tightens everywhere. Think of it as a version of ‘crowding out’; the Treasury issues debt into a not-very optimistic economy, squeezing bank lending capacity as piggies fight to hold or expand HQLA or ONRRP.
An inverted yield curve is a good predictor of recessions because it removes the incentive for banks to lend; to borrow short and lend long. The current interest rate may not be especially high at ~5%, but the yield curve is the most inverted since 1980, the heyday of Paul Volcker. Given its current size, the composition of the Fed’s balance sheet becomes very important.